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   ARTICLE   |   From Scotsman Guide Commercial Edition   |   August 2012

What’s in Your CMBS Workout?

Ensure your client’s loan workout plan has the right components

Many commercial mortgage brokers  representing small and medium-size borrowers may find themselves at a loss when dealing with a commercial mortgage-backed securities (CMBS) loan that is in distress. Coming up with an effective workout solution hinges on key components that are associated with the quality of operations, loan documents, assets, etc. That is why it is essential for brokers and borrowers alike to understand the basics of these workouts and to partner with the right team. 

"Because there often is not a second chance to get it right, a borrower must be proactive in creating an environment that preemptively counters any potential misconceptions."

To start, it is important to realize that the workout process for a CMBS loan is influenced by the acquisition, financing and operation of the asset. Having detailed and thorough record keeping is critical, as it serves and establishes a trail that can be looked back on at a later date for many reasons — including if there is ever the need to formulate a go-forward restructuring plan. 

As it relates to restructuring, special servicers make their own assumptions by conducting due diligence on the asset, reviewing the loan documents and referencing the appraisal as a guide. Because there often is not a second chance to get it right, a borrower must be proactive in creating an environment that preemptively counters any potential misconceptions. In addition, experience in the area of turning around properties and asset restructuring help formulate a reasonable story that not only highlights the issues, but prescribes realistic and mutually acceptable solutions, as well. One must assure the servicer of a sustainable restructure rather than a short-term fix.

Quality 

The quality maintenance and operations of an asset is an important factor in creating an effective workout environment that favors the borrower. Proactive owners maintain a high level of curb appeal and tenancy attraction even in the best of times, and it certainly pays off in the worst. A workout can’t be a mere financial transaction; it must include a detailed property-turnaround program to spur new revenue streams and instill confidence in the special servicer. Sustainable restructures focus on ways to increase the property’s cash flow, so that it can return to profitability and perform up to the lender’s and borrower’s adjusted expectations.

Remember, the special servicer’s asset manager is equipped to assess the quality of borrowers’ operations and business practices, and as part of that, the operations and cash-flow statements may be picked apart. Special servicers may cut professional operators some slack and respect their opinions, but operators that squeeze every last nickel out of their properties may find resistance to their proposals. To put it plainly, a perceived poor operator may need to relinquish control to a third-party investor to get any restructure approved.

Because it is the servicers’ job to ensure that the bondholders receive the best net present value, they must take into account many factors, including market forces and the quality of the borrower. Substandard operations and maintenance add another hurdle to overcome in convincing the servicer to agree to restructure. The servicer may believe that the distress is attributable in part to the borrower, and therefore be reluctant to restructure a loan for a borrower that won’t maximize the opportunity and benefits that restructure provides. A typical concern is that the borrower may be back at the workout table in short order asking for a second round of concessions — for a further deteriorated asset.

Knowledge 

Another important component in preparation of a workout is the knowledge of the loan terms. A skilled commercial mortgage broker and competent legal counsel help ensure that borrowers are informed of the content of the loan documents and their obligations. This knowledge is imperative to avoid default, or even worse, trigger recourse. Explain to the borrower what is required and how the servicer will maintain a delicate equilibrium, and ensure that mistakes on either side is immediately addressed in a collaborative fashion. In addition, knowing the loan documents can help identify clerical errors like charging the wrong rate, or collecting more or less reserves than required. 

To some borrowers’ surprise, however, overzealous special-servicing asset managers occasionally may push the envelope. A common occurrence is a borrower’s request to release escrow funds allocated toward leasing costs. The special servicer that analyzes the asset may determine that even with the new lease-up, the asset still has a high chance of default. 

Furthermore, if the leasing fees are not released, the money in reserves may at least be considered as additional “cash collateral,” or money that can be recovered in the event of foreclosure.

Based on that calculation, and the assumption that the borrower probably will pay the leasing costs out of pocket and chalk it up to servicer bureaucracy, the servicer may deny the request and see what happens. To compound matters, the explanation provided by the servicer even may not be found in the loan documents. This action alone can push the property into default, at which point the servicer certainly would deny the request and insist on a receiver to administer the process while the accrued and default interest piles up. This default, in essence, may let the servicer off the hook unless the borrower decides to sue for damages, which most borrowers don’t do because the issue of their default overshadows the servicer transgression. It is hard for a borrower to prove that it would have not defaulted otherwise. Borrowers who are familiar with the terms of the loan documents can get out ahead of such issues and avoid a larger headache. 

Surveillance

Be pragmatic in assessing the issues facing the asset by looking out for and identifying trends. This will assist with projecting distress and formulating a strategy that addresses and prevents the continuation of negative trends. If the property or income is declining toward distress, acknowledge the issue, understand why and be definitive in any actions. Your clients will be guided by their:

  • Keeping good records, 
  • Maintaining the asset properly, and 
  • Knowing the loan documents.

Because dealing with a special servicer can be unique and difficult, you probably should advise clients to seek help from a loan-workout professional who has the experience and specialization to understand what takes place on the other side of the curtain, navigate the minefields, neutralize threats and work to restructure the deal.

Remember, a special servicer is limited in terms of what they can or cannot do when it comes to restructuring a loan. That is because they are subject to a pooling and servicing agreement that essentially dictates a concrete set of terms to which the special servicer must abide. In addition, each special servicer has a unique set of resolution options that they will accept, although these internal policies can change overnight. Unless executed properly, restructuring negotiations will seem to be one sided with borrowers negotiating against themselves without a counter. Make sure clients are partnering with the right team that has the experience and knowledge to leverage their position. 

Professional help

Because no workout or restructure process is possible without a solid legal strategy, a restructuring adviser should convene with the borrower’s legal counsel and prepare a legal contingency/companion strategy. Regardless of whether a distressed asset is in foreclosure or not, the borrower must make the necessary plans for the ultimate struggle. It also is critical to ensure that the workout adviser and legal counsel complement each other. Synchronizing their individual actions will provide for a unified and effective strategy that will enhance the probability of their efforts. In most cases, special servicers employ a dual-track approach of simultaneous foreclosure and negotiation. This means that as the foreclosure process proceeds, borrowers’ time window within which to strike a deal evaporates and so does their leverage.

If your clients decide to seek professional help, they should consult a loan and/or property restructuring expert as soon as they detect and can illustrate a trend that will result in a default. Obviously further analysis will be needed, but this analysis is best conducted by a professional who can formulate a viable restructure strategy.

Special-servicing companies employ a number of asset managers — each differ in their personality and mannerisms. These special servicers, however, are granted the right to do their duty as a result of a parties’ control of the riskiest bonds backed by mortgages in the CMBS pools. These parties are known as the controlling-class representatives (CCR). The CCR appoints and effectively heavily influences the special servicer’s strategy in dealing with loans in the trust. A debt-restructuring adviser must know the lender and understand who is pulling the strings. It is also critical to understand to what extent the CCR is still in the money, or whether it is on the precipice of the next set of bonds immediately preceding them taking control as CCR, and perhaps appointing a new special servicer — forcing a borrower to start the process all over, with some of their cards already having been revealed.

There has been much press given to the conflict of interest of special servicers representing a CCR that is no longer in the money. Because the only way for these special servicers now to generate revenue is through fees billed to the more secure bondholders, some special-servicer asset managers — depending on the level of professional integrity and ethics — would be less focused on delivering the best result to the trust, making it imperative for the borrower’s representative to be diligent.

Exit strategy

Every workout must have an ultimate goal or an exit strategy that is carefully planned and formulated to profit the borrower. Otherwise, the process and effort would all be for naught. Almost every workout involves the borrower contributing additional capital, whether it is a discounted payoff of the loan, additional reserves deposit, or a partial pay down. The borrower must know its investment capabilities and guide the adviser as to the level of cash it can raise. Obviously, there is the possibility of bringing in new partners based on a pro-forma of the asset, but it is important nonetheless to have a workout plan that is modeled to fit with the type and amount of investment capital available.

• • •

Workouts are a form of crisis-management rather than a profit center. Whether it is a restructure, discounted payoff or even handing over the deed for consideration, hope for the best, but plan for the worst. Explain to clients that they must be pragmatic and understand that you need to assess today’s options against today’s values. The workout must be treated as a new day, because if you try to recapture yesterday’s entire investment capital in one fell swoop, you will be disappointed.  


 


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